The anti-competitive tactics and protections of most German small and medium enterprises have to be addressed for Germany to return to sustained solid growth. Labor market reform such as that already undertaken in Agenda 2010, while necessary, is insufficient. In fact, an excessive focus on labor market reform alone may imperil the success of the overall reform effort, both politically and economically.

No one should be fooled by the oft-cited export success of some small German firms, such as the leaders in Maschinenbau (machine tools). First, those firms do not represent the whole or even most of the Mittelstand sector-domestic services and various forms of skilled crafts along with less competitive manufacturers comprise most of Mittelstand employment, and these are largely inefficient. Second, exports are not the criteria by which to judge the success of the German economy. Profitability and growth prospects are what matter.

And third, it is easy in every market economy to cast the small- and medium-enterprises as the most dynamic sector, as compared to large firms, but that does not mean they are living up to their potential. Just as in every home children tend to run around and grow more than the adults, small businesses will show more activity than large businesses on average. The question is whether the German smaller businesses are dynamic by comparable standards to the smaller businesses in other countries, and they are not. A greater share of the larger German businesses does meet or exceed international standards for such developed firms.

The Mittelstand is not the victim of international (low-wage) competitive forces or of government regulation imposed on it from the outside. It is anti-competitive because the entrenched owners and management want it that way and keep guild barriers and regula-tions they have sought in place. In the retail sector, numerous restrictions on land use and on discounting keep small stores in place and competition away, limiting efficiencies of scale (shop hour restrictions are just a side-show). “Master” qualifications and other supposed “quality” restrictions (such as those on water for German beer) constrain consumer choice and create barriers to entry. Manufacturing remains a disproportionate share of the German economy because entrenched owners and workers are able to resist reallocating capital to new sectors and businesses.

The government-supported fragmentation of the German banking system and suppression of shareholder rights further aid the inefficient Mittelstand companies in their defense of their protected positions. Politically swayed local Sparkassen give low cost funding to incumbent businesses, subsidizing their existence and distorting returns. The emphasis on banking relationships and steady ownership for privately held companies, the banks’ voting of share-holders’ proxies and large cross-shareholdings for those companies with traded shares, and the lack of financial incentives for consolidation in either category keep pressure off of management—and keep the German economy operating below efficient scale in most sectors.

For the German economy to grow and improve productivity, it is not enough to talk about “Anglo-Saxon-style finance.” Such talk has to result in actual rationalization, and it is not only labor regulations that prevent rationalization. The privileged position of Mittelstand owners and management is just as much a source of resistance to efficiency. One way to see this is in the OECD studies that show that while start-ups of new businesses are about as common per capita in Germany as in the United States (even before the recent changes to encourage founding Ich AGs), the average scale of business is much lower, so there is no consolidation and few economies of scale achieved in Germany.

Politically, reforms will not be sustained without showing an equal sharing of the visible “burden of adjustment” between capital and labor. The breakup of the mutually reinforcing system that keeps current businesses protected and small, and current union leadership in place is needed as well. None of this will happen with labor reform alone. The privileges of German management and of small-business ownership must be attacked directly, too.

Given the decades of propaganda about the supposed benefits for Germany of the Mittelstand, and the interlocking self-serving incentives of local banks, unions, politicians, and managements to keep the system in place, these corporate reforms will be at least as hard to implement as the current Hartz IV labor reforms. The Green party has made some rhetorical steps in this direction by emphasizing libertarian values and the need for sustain-ability across generations. It remains for either of the larger parties-more logically the SPD, having already taken on the unions to some degree-to pick up this emphasis.

Two possible means for the current or future German governments to achieve this over political opposition are to a) use EC rulings to overcome vested interests within German society (as the Red-Green government did with the Landesbanken, but as they are still resisting with the golden shares of VW) and b) rhetorically and politically link the viability of the welfare state to generational change in corporate governance.

The Schroeder government's reform priorities and determination are admirable, but the program so far is incomplete. The incompletion is the imbalance in reforms emphasis between labor and capital, perhaps surprising from a Red-Green coalition. The standard by which to judge economic reform is not whether Germany has converged on the model of the US economy, which is neither necessary nor desirable. The standard to meet is whether Germany has removed enough of the privileges of special interests-those of protected Mittelstand management and the Sparkassen as well as of labor-to make the welfare state sustainable. This is feasible, but not yet in sight.